There is a huge reason why tech firms don’t pay dividends: their employees have stock options. Unfortunately, although dividends paid to shareholders lower the share price, the strike price on employee options is not adjusted for the lower share price caused by dividend payments. Thus, paying dividends hurts the value of employee stock options, so tech firms that use options NEVER pay dividends.
Also, in terms of returning retained earnings to investors, there is no difference between a company paying dividends and a company repurchasing shares (assuming the shares are fairly valued). Happily, though, when a company repurchases shares, it doesn’t affect the strike price of stock options. Thus, tech firms don’t pay dividends and they repurchase shares instead. So in addition to the "dividend yield", we also need to add in all the capital that Microsoft spent on share repurchases, which was $47.7B in the fiscal year ending in June 2009 (http://www.microsoft.com/msft/reports/ar09/10k_fr_fin.html). That ain’t nothing.
As an aside, Microsoft started paying dividends only after switching from using employee stock options to using restricted stock (the value of which isn’t affected by dividend payments).
These points aside, the author has a good point, which is that more tech firms should do more to return retained earnings to shareholders (whether via share repurchases or dividends).
I disagree with the notion that dividends paid lower the share price. Is there a theoretical reason? Or is it observed in practice? I would very much like to learn more about this if you could send pointers.
To me this looks more like a device used by managements to justify their practice of share repurchase. The options should be repriced not when dividends are paid but rather when stock repurchase is done. Like you mention, stock repurchase never affects the strike price of options. There is a very informative comment on stock repurchases by Warren Buffet in this 2005 annual report - http://www.berkshirehathaway.com/2005arn/2005ar.pdf
Sure, dividends lower the stock price in practice. Lots of mutual funds even warn about timing purchases right before dividends. The phrase you'll want to google for is "buying the dividend".
Paying out cash on hand should reduce the share price, because money in the bank is proportionally owned by the shareholders.
For an extreme example, imagine a hypothetical company with 1 billion shares outstanding and $1B in the bank and no other business than earning interest on its cash. With $1B in the bank, it should be valued at $1/share plus some share of expected future interest payments. Pay out a $1/share dividend, and the company is now worth $0.
Hmmmmm. This would explain it - but for the fact that dividends are generally supposed to be paid out of profits not out of cash in the bank. Aren't dividends a way of sharing profits with shareholders, not sharing the net worth of the company. If a company is not making any profits, it should not pay any dividends.
Your hypothetical example though is a very useful way of understanding these things.
Infact it just helped me understand clearly why companies should keep as little cash as possible - unless they can generate returns better than atleast govt bonds.
If not paid as a dividend, where else would that profit go but to cash in the bank at time T+1? (Technically, it's free cash flow that goes to cash in the bank, but the difference isn't meaningful here.)
Huh? share price is determined by one thing and one thing only, market demand.
As twitter has shown, valuation does not need to correlate to any traditional financial metric whatsoever. Twitter is worth 1 Bn becomes someone decided to pay for a stake at that valuation. No other reason.
Right, it's like the late night infomercials that sell various stuffs....usually with a 2-for-1 offer at the end of the commercial and a discount...all followed by a statement "A 120 dollar value! Yours for $19.99"
Sure, but the fundamental value of the share obviously goes down at the instant the company pays out a dividend, so the expectation is that the companies price will drop.
Since everyone expects it to happen it generally does.
Except that dividends are announced well in advance so if the price did drop automatically on the day the cash is paid out, it would be trivial to short the position.
The fact is, there is nothing predictable in the stock market.
edit: as BobbyH points out, my point about shorting is mistaken but that does not change the key point about unpredictability of the markets vis a vis declaring a dividend.
A good example of dividend behaviour can be seen in the 16th December dividend from Sycamore Networks (see http://www.google.com/finance?q=scmr). This dividend was announced on the 18th November (roughly a month before the effective date). The share price doesn't change at that point, but on the effective date it falls by $9.70, almost exactly the dividend amount of $10. I chose this example as Sycamore gave out a quite ludicrous amount of cash (something like 35% of the company value) so the price drop is very obvious. Another unusual feature of the dividend is that the pay date is actually before the effective date. The dividend is paid on the 15th December, even though its the people who own the shares at the market open on the 16th who qualify for the dividend. This comes about due to a rule that NASDAQ have that if a distribution is greater than 25% of a company value, then the effective date is set to be the day after the pay date.
I think that while there is a lot that is unpredictable about the stock market, you can be fairly sure that on a dividend's effective date, the share price will fall by roughly the amount of the dividend. It won't be exact due to all the other factors which would affect a stock's price on any day, but it will be roughly correct.
I agree with the basic argument, but for most of the 1980-2000 period it was more tax efficient to return money to investors through long term capital gains, rather than dividends. This situation will return next year if the Bush tax plan expires.
The answer is very simple. Invest in companies that pay dividends, like telcos, electrical utilities, steel mills, railroads and other giants of the the 20th century. Note that you wont get any stock appreciation to speak of. Tech companies that dont invest in new markets die when competitors make the move. Apple might very well be dead if it tried to live of the Mac franchise.
Companies are allowed to keep their income so long as it is necessary for their business. You might think that a mom and pop store would be allowed to keep millions in cash, but since that kind of money isnt necessary for the operation of the business the excess gets taxed at 80%. (My info is old so the exact percentage may be out of date.) Large tech companies like Microsoft and Intel pay nominal dividends to keep the Federales at by, not out of generosity to their stockholders.
"Tech companies that dont invest in new markets die when competitors make the move."
He moves on to say that these tech giants usually end up dying anyway, so he is suggesting they "die with dignity" or at least realize when they should stop growing into new markets tangential to their core competency.
In theory yes, repurchasing shares should do just as well as paying out dividends.
In practice, no.
Most companies are run by people who are utterly bad at allocating capital. They will buy stock back when it is overvalued, when it is trading towards its high because they feel on top of the world and unstoppable. They are almost always making a grave mistake.
Share buybacks need to be used like Henry Singleton at Teledyne:
You buy back stock when it is trading towards its lows and likely undervalued.
You issue stock and use it as currency for acquisitions when it is trading near highs so that you take advantage of its overvalued status in the market place.
Singleton showed how to properly allocate capital in tech and do it in a way that enriches everyone. That's why most people today look to what he did at Teledyne as models for best practices in capital allocation.
It's not really about high and low, it's more about valuation. If you can peg your valuation at $20 per share based on a variety of factors related to your revenue, free cash flow, discounted growth, etc., but your stock is trading at $12/share, your company is undervalued and a share repurchase may be a good idea. But if your stock is trading at or above $20/share, yet you can't make the case that your company is actually worth more than $20/share, it's foolish.
> His view is that there is no way to be a truly long-term investor in tech companies because management never allows companies to transition from growth companies to mature, income-oriented ones.
I'm not sure if this is true if you looked at the tech industry as a whole. I think it is, but my view is biased from almost purely following GOOG, AAPL, MSFT, etc.
But if it is true, it would be a good explanation as to why Warren Buffett does not invest in tech companies.
The argument seems sound to me, except that a company like Apple is such a great counter example. In 1997, Michael Dell was famously quoted when asked about what should be Done with Apple (a company that Steve Jobs had _just_ returned to)
"What would I do?" Mr. Dell said to an audience of several thousand information technology managers. "I'd shut it down and give the money back to the shareholders."
The rest, is as well all know, history - Apple became worth more than Dell in 2006, and today, is worth almost six times as much as Dell.
I'm pretty certain Apple investors are happy that Apple didn't start issuing dividends and run the company on its (by then dying) Mac OS 8.x, but decided to completely reinvent itself on NeXT OS (aka OS X).
I don't think the comparison is applicable here. In 1997 Apple was clearly not in a position to transition from a growth-oriented company keeping it all for investment, to a profit-oriented company paying back a large chunk of its profit to shareholders. In 1997 Apple profits were minus 1 billion dollars. Even if you factor out Next buyout (400 millions), that's still deep down in the red. Not profits to distribute.
But that would definitely apply to 2010 Apple & Microsoft : should they continue to look for growth at all cost, or start paying big (bigger) dividends to shareholders? I lean toward investing... continue to try to change the world, please. Even if lately Microsoft seems to be bad at it (but are they really?), trying to follow the leaders instead of implementing a vision, it doesn't mean it's too late...
The tech companies, by not paying out dividends, are in effect telling shareholders that they can invest the profits better than them.
This belief I guess comes out in part due to the meteoric profit growth that successful tech companies witness which leads to hubris in the management. The other reason for this belief is the shareholders themselves who let management invest profits in any project they want in the hope of ever increasing profits and stock price.
About microsoft's dividends, one thing the article misses is that msft's payout is very high but most of it is via stock repurchases.
The reality is that managements of all companies - tech or otherwise - concentrate on their own interests. That is why you see companies spending so much on stock repurchases rather than pure dividends. In theory it reduces the number of shares - but in practice it is a device to prop up the stock price so stock options or stock price linked benefits for employees and management are profitable. Microsoft spends disproportionately higher on stock repurchases compared to dividends. If they paid all that money as dividends, it would be a very decent dividend paying company.
It would be interesting to take a poll of ms shareholders to see if a majority want the dividend raised. It would be a great test to tell how broken corporate governemxe really is.
I think the issue is that often tech company founders / management have preferred shares and therefore greater voting rights than general common stock shareholders. So even if a large group of common shareholders wanted to see dividends, they wouldn't have much authority.
I may be wrong though, I'm just starting to learn more about corporate finance.
This is true. Most companies are structured so that there exists a preferred share class with greater voting rights so to pass anything you'd have to get buy in from the board members who are the ones who typically own this share class.
They do - it's called annual shareholder meeting where shareholders vote on issues. Getting something on the ballot isn't that hard, provided a lot of people care about the particular issue.
They probably do it because dividends are seen as somewhat obsolete, but firms have to continue paying them because they set a precedent. They are small because they have to be consistent or investors freak out, so the actual earnings aren't distributed anyway. I'd personally rather not have dividends for several reasons:
1. the stock price should accurately reflect the earnings of the firm. When a dividend is announced, the price of the stock decreases by the amount of the dividend. If you want some of those earnings, then sell a share. There's no need for the company to issue a dividend. This is a common misconception most people have.
2. You're taxed on the dividend payments (exceptions tax deferred retirement accounts). This is annoying, especially if you don't want them now and would rather have them just reinvested. Ignoring taxes, the value to the shareholder is the same regardless of whether dividends are paid or not.
My professors in finance all go on long rants against paying dividends, and it really does seem that they're antiquated. Most newer firms just don't pay dividends, and tech companies just happen to be newer firms usually. It's not necessary a property of just tech companies.
I fail to see your argument. The owners make money without receiving dividends. It's reflected in the stock price. When a dividend is issued, the stock price goes down by exactly that amount. It's the exact same thing. If you want that money, sell the stock. My argument is that from a tax perspective, it's more beneficial for the owners for the company to NOT pay dividends. If you ignore taxes, they're identical.
Put another way:
Company X's stock is $100/share. They issue a 50 cent dividend. The stock price will go down to $99.50/share upon announcement. The investors/owners still have $100 whether the dividend is issued or not, except the investors have to pay taxes on that 50 cent dividend now instead of having it re-invested.
That's a very one-dimensional view of investing though. The Bogle (the founder of Vanguard) school of investing says that investing in the hopes the price will go up or down is nothing but speculation on the same level as investing in commodities (a barrel of oil does not do anything, it just sits there and is worth what the market says it is worth).
This traditional view holds that companies are fundamentally different than barrels of oil, in that they can produce wealth and provide reasonable returns to their share-holders year after year and that you can take your 7% appreciation at the rate the economy grows (or at least used to).
Timing the market is certainly a valid (if highly risky) strategy, but it's only one view of investing. It's only in this strategy which dividends don't make sense.
In that case, you're selling your ownership in the company in order to make money. Dividends pay their owners without attenuating their voting power. This might now be very useful in the modern marketplace, but from a historical perspective, and from a small business perspective, they are VERY useful.
Stock used to represent ownership of a fraction of the company's assets and the right to that fraction of its profits. The share price converged on the net present value of the expected dividends plus the market value of the assets.
Now that most companies refuse to wind down except in severe distress (you'll only get a sliver of the assets' market value) and don't pay dividends, the connection between profits and the investors is severed. The only reason share prices are vaguely correlated to profits is that investors are speculating on each others' faith in a mystical connection between profits and share prices. It's like a baseball card with the name of your favorite sales team on it.
The economy would function better if it rewarded buy-and-hold investors for good long-term governance of companies. Instead we tax dividends harder than selling out, make the share price all-important, and reward exponential over-expansion (that's largely where profits go, it's psychologically impressive even if it's less profitable) and market-timing speculators' games.
"Put another way: Company X's stock is $100/share. They issue a 50 cent dividend. The stock price will go down to $99.50/share upon announcement. "
That statement is patently incorrect, in theory and in practice.
PRACTICE
The share price of companies that announce dividends every quarter has little immediate correlation to the dividend announced. In the long term, companies that consistently raise dividends year over year actually increase in value. (These are affectionately referenced as "dividend darlings" and are a focus of some investment strategies.)
THEORY
The purpose of a company is to make money. You do this by spending capital to create a product. Once you sell that product, you regain back the capital you invested in earnings. The goal is to eventually make back more money in earnings than what you invested in capital.
If I buy a bar in my neighborhood for, say, $100k, I would expect to make money back on it. If I worked hard to build a clientele and earned something like $30k a year from my customers (a spectacular return, by the way), then the bar would be earning money. I could then afford to pay some of that out to the shareholders - in this case, just me.
What your notion of dividends seems to be is a cannibalization of the equity present in the company. If the company has no product of intrinsic value, then yes, your example might hold true. In the bar example, you would believe that the bar is worth only $100k (the price I paid) and that any money I pay out would be coming out of that $100k. This would be true only if I did not work to get customers and therefore did not make any money over the year.
SUMMARY
For companies that provide value in the form of goods and services, the money you get out of it will be more than the money you put in. This frequently, and oftentimes should, take the form of dividend payments.
ALTERNATIVE
Having said all that, there are very legitimate reasons why tech companies do not pay out dividends, namely that they reinvest the profits in research and development to produce new and better products. I don't think anyone who bought Apple stock seven years ago is complaining about the lack.
I have to agree with ingenium here. I've haven't taken a finance class in my MBA program yet and I'm not in that industry. But I feel that dividends are just a company forcing me to pay taxes early. If tax rates on dividends were lower than capital gains, I would welcome them, otherwise, I'll sell the stock when I need money.
I don't feel this an explanation of why they hold on to the cash. More an explanation of why even large tech companies are perhaps not the best long-term investments.
Also, in terms of returning retained earnings to investors, there is no difference between a company paying dividends and a company repurchasing shares (assuming the shares are fairly valued). Happily, though, when a company repurchases shares, it doesn’t affect the strike price of stock options. Thus, tech firms don’t pay dividends and they repurchase shares instead. So in addition to the "dividend yield", we also need to add in all the capital that Microsoft spent on share repurchases, which was $47.7B in the fiscal year ending in June 2009 (http://www.microsoft.com/msft/reports/ar09/10k_fr_fin.html). That ain’t nothing.
As an aside, Microsoft started paying dividends only after switching from using employee stock options to using restricted stock (the value of which isn’t affected by dividend payments).
These points aside, the author has a good point, which is that more tech firms should do more to return retained earnings to shareholders (whether via share repurchases or dividends).